RISK MANAGEMENT IN BANK LENDING A CASE STUDY OF EQUITORIAL TRUST BANK

ABSTRACT

The  emergence of  Banks  owned  by  the  local  private sector began in the mid-1970s. Financial markets in the period since independence have been dominated by foreign and government owned commercial banks. But deficiencies in financial intermediation   provided   an   opportunity   for   local   private investors to enter financial markets. Between the late 1970s and the mid-1980s, 13 local Banks were set up in Nigeria. The growth of local banks accelerated dramatically in the second half of the 1980s, with 70 Commercial and Merchant Banks established between 1986 and 1991 when the Central Bank of Nigeria suspended issuing new licenses: almost all  of  these were wholly owned by local investors.

In Nigeria, the rising cases of bank distress have also become a

major source of concern for policy makers. As a result of attractive interest rate on deposits and loans, credits were given out indiscriminately without proper credit appraisal. The resultant effects were that many of these loans turn out to be bad. It is in realization of the consequence of deteriorating loan quality on the banking sector and the economy at large that this paper is motivated. This paper, therefore, attempts to evaluate the effect of risk management in bank lending, using Equitorial Trust Bank as a case study.

CHAPTER ONE INTRODUCTION

1.1  BACKGROUND OF THE STUDY

The Nigerian financial institutions have faced difficulties over the years for a multitude of reasons but the major cause of serious banking problems in  recent times continues to  be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counterparties. Credit risk is most simply defined as the potential that a bank borrower will fail to meet the obligations in accordance with agreed terms. The goal of risk management in bank lending is to maximize a bank’s risk adjusted rate of return, maintaining risk exposure with acceptable parameters.

The problem of Bank distress in the Nigerian Banking Sector has been observed since 1930s. In fact, between 1930 and

1958, over 21 Bank failures were recorded. The Bank failures during the time were attributed to the domination of foreign Banks in terms of the exclusive patronage by British firms.

Other factors that led to mass failure of the indigenous banks were low capital base, lack of managerial expertise and untrained personnel.

The deregulation of the financial system was embarked upon by  the  military  administration  in  1986  as  part  of  the Structural Adjustment Programme (SAP). The deregulation witnessed sharp changes in banks’ operations, regulatory environment and the distress syndrome resurfaced again in Nigeria. The changes brought about by SAP included the liberalization of the foreign exchange and money markets, the introduction of prudential guidelines and accounting standards, increase in minimum paid-up capital, establishment of Nigerian Deposit Insurance Corporation (NDIC), relaxation of mandatory sectoral allocation of credits, etc.

The Late 1980s and early 1990s were years of financial boom, as the number of players increased substantially in the system? For instance, between 1986 and 1989, about 38 new commercial and merchant banks were created. The increase in

the number of banks over-stretched the existing human resources capacity of banks which resulted to many problems such as poor credit appraisal system, financial crimes, accumulation of poor asset quality, among others. The consequence was increase in the number of distress banks. During 1994 alone, two banks had their licenses suspended (Republic Bank Ltd and Broad Bank of Nigeria Ltd). Another four banks has their licenses revoked. Also in 1994, the number of banks adjudged distressed by the Central Bank rose by 10 to 42, excluding the four banks that were closed during the year. By the end of year in 1994, non-performing loans and advances constituted about 60.33 percent of the total deposits of the entire banking industry. Furthermore, the ratio of non-performing loans and advances to the total loans and  advances  in  the  entire  banking  industry  was  43.03 percent while that for the distressed banks was 64.5 percent according to CBN Annual Report 1994. By the year 1998, up to 31 banks were being liquidated.

The Global Financial crisis is yet to run its full course, but is already one of the largest crises ever experienced according to the existing literature. With its roots in banking, the sub- prime mortgage crisis that commenced in the United States in

2007 soon resonated in other sectors of its financial system, and the economy at large. The crisis later spread to Europe and now has become a  global phenomenon. The emerging economies were not isolated. In the wake of the United State Government bid  to  boost  housing  was  a  policy  error  that permitted sub-prime clientele unrestricted access to mortgage finance. Combined with the thriving derivative market, the horizon for credit expansion widened to unprecedented levels. The  result  was  private  over-borrowing accompanied  by  an internal debt crisis. As long as capital flows and credit expansion grew unchecked, lending expectedly spilt over from financing safe and productive investments to risky and speculative assets. Housing prices had trended upwards for ten consecutive years up to 2004, enticing speculators. Mortgages perfected imprudent lending practices.

The cannons of basic lending were never followed in credit creation.  Credits  were  generally  not  collaterized  in   the mortgage sub-sector.

Credits, especially in mortgage finance and commercial real estates  were  excessive  to  the  repayment  ability  of  the borrower. The housing market was overpriced. Investors borrowed to enter the booming overpriced market without a thought that the market could ever crash. It crashed unexpectedly and commercial loan defaults became widespread. Financial institutions gradually became illiquid. Available stocks were dumped on the capital market to shore up liquidity. Banks became unwilling to lend to one another. The financial system was weakened by runs, bankruptcy, takeovers, job losses and bail-outs. United State financial institutions failed to honour maturing investments, especially placed by foreign investors.

The Nigerian economic recession of 1982 could not have dragged the rest of the world into a global recession because the quantum of foreign investments in the Nigerian economy

was minimal. Although there were defaults in the return of deposits, it was an internal affair. Nigeria was in it alone and had to steer to good financial health on its own accord. There is hardly any bank anywhere in the world that does not have correspondence arrangement with a bank in the USA, at least for the confirmation and settlement of letters of credit as well as for the transfer of funds. By arrangement, all such idle funds are invested in the American financial system, especially on high-yielding derivatives.

According to October 2008 IMF World Economic Outlook, the global financial crisis did not have any direct and serious consequences on  sub-Saharan African, of  which Nigeria  is one. However, Nigeria feels the pinch in various ways such as difficulty in sourcing new credit lines by banks and real-sector operators from abroad, possibility of non-renewal of expiring credit lines to banks sourced from abroad, withdrawal of liquid assets and other investment portfolio by foreigners, reduced inflow of foreign direct investments etc.

As at third quarter of 2009, there was a shift in the Nigerian banking system as a result of audit carried out by the central bank of Nigeria, the apex regulatory body, on Nigerian banks. Consequent upon their findings, the CBN replaced the leadership  of  Eight  (8)  Nigerian  banks  and  injected  N620 billion of liquidity into the sector for a rescue. This was a natural  consequence  of  bad  lending  decisions  by  banks leading to huge provisions and erosion in their capital. A bulk of depositor’s money was lent for speculative purposes in the capital market. The attitude of some borrowers who are unwilling to repay even when they are known to have the means  to  service  their  debts.  Such  borrowers  seek  refuge under the inadequate legal framework and cumbersome loan recovery processes which make it difficult for the lending bank to foreclose collaterals. Obtaining judgment when a loan defaulter is sued is often lengthy, thereby increasing the cost of banking business in Nigeria. In the case of some small borrowers particularly in  priority  sector  of  agriculture and small and medium scale enterprise, they willfully defaulted on the wrong notion that the bank loans are part of their share of

the “national cake”. There are also borrowers who through connivance with some banks’ staff take bank loans with no intention  to   repay  such   loans.   These  problems  greatly impaired the quality of banks’ assets as non-performing loans and advances become unbearable and turn out to be a high burden on many of them.

Insider abuse by  bank  owners, directors and management staff is another factor which exacerbated loan defaults in some weak banks. Insider in those banks obtained loans and advances without adequate collaterals in contravention of banking regulations. Sometimes, the loan applications were poorly appraisal with inadequate documentation. Poor lending and  borrowing culture  was  contributory to  distress in  the system.

1.2  STATEMENT OF THE PROBLEM

The banking sector has a crucial role to play in the growth of Nigeria economy. A strong and viable banking industry which can facilitate local and international transactions is a necessary mechanism that any international investor would

consider amongst other things prior to taking such investment decisions.

The cornerstone upon which every successful financial institution is built is nevertheless, a strong and effective credit management process. A process which reinforces and complements corporate objectives and goals. Managing risk requires a top down approach. If the board and bank executives are not supportive of the efforts, it will be difficult to assemble   the   resources   to   control   the   risks   deemed acceptable. Wanting to manage the risks identified must be a part of a corporate culture. As risks are identified and a means to control those risks is also enacted, the organization has to have the ability to adapt.

It is in view of these, however, that this research paper undertakes to examine banks and the strategies in place to stem the tide of non-performing loans. The statement of problem is to critically appraise risk assessment techniques and suggest measure(s) that improve the quality of risk assets in banks.

The outcome of this research study is expected to assist stakeholders in the Nigerian baking industry in addressing the following inherent problems;

           Reliance on the financial statements of the borrowers as a basis for lending which is fraught with serious danger.

           Lack of understanding of the borrower’s business skills and credibility

        Adequate collaterization of credits

        Subvention of regulatory guidelines on credit creation

           Lack of data/information concerning the economic and political situation that impact negatively on the debtor

           Creation   of   new   loans   in   total   disregard   to   the performance of the existing ones.

1.3  RESEARCH QUESTIONS

It is widely believed that the major cause of distress in the banking system is as a result of poor risk management. To establish this premise, it is important that we find answers to the questions below;

           Do  the  board  of   executive  directors,  credit  review committee and others concerned in credit administration function effectively?

           Are there established risk management procedures and programmes that are well documented and entrenched in Nigeria banks?

           Are  credits  limits  set,  and  are  these  limits  strictly monitored to  avoid  extension  of  excessive  credit  to  a specific counterparty?

           Do the volumes of the banks’ risk asset have impact on its gross earnings?

1.4  OBJECTIVES OF THE STUDY

The extent of distress in banks in Nigeria has become a source of worry to the banking public. This, to a great extent, has eroded the confidence of the public in the financial system. It has always been asserted that the major cause of failures in the system was as a result of non-performing credits engendered by insider abuse by bank owners, management staff, willful defaults by borrowers, etc.

In view of the risks prevalent in the credit risks management in Nigerian banks, this study is meant to:

           Identify lapses in  the  management of  credit  risk  and proffer  corrective  measure(s)  to  enhance  the  banks overall credit quality.

           Ascertain the bank’s capacity to assess risk with regards to the analysis and monitoring of the dynamics in the operating environment with a view to evaluating its impact on the bank’s past, present and future credit decisions.

           Assess the role played by the regulatory authorities in enhancing bank’s risk management.

           Identify if the perceived risk in a credit are matched by commensurate return through appropriate pricing of facility.

1.5  RESEARCH HYPOTHESIS

The hypothesis to be tested in the course of this research is related to research Question One and the last question: Do the board of directors, credit review committee and all concerned

in credit creation function effectively and do the volume of banks’ risk assets has impact on its gross earning? This leads us to the following hypotheses:

HYPOTHESIS

H1:   The volume of the bank’s risk asset has no outstanding impact on its gross earnings.

H2:   There is no correlation between the bank’s risk asset portfolio and the effectiveness of its credit risk management system.

1.6  SCOPE OF THE STUDY

This study is set to analyze the credit risk that is inherent in Nigerian banking system. This is prompted by the need to have    an    efficient    and    effective    risk    management program to stem the tide of distress in Nigerian banking industry. Data from both qualitative and quantitative sources will be used to gain an insight and knowledge of the Nigerian banking industry.

1.7  SIGNIFICANCE OF STUDY

Sequel  to  the  enormous  challenges  before  the  banking institution  in  Nigeria  in  the  management  of  their  credit portfolio in ensuring minimal loan loss through maintenance of high quality risk assets while optimizing returns, this study is focusing on the potential financial loss resulting from the failure of customers to honour fully the terms of a loan. The paper  will  also  examine  the  role  played  by  the  regulatory authorities  in  enhancing  bank’s  overall  risk  management through checks on compliance to credit policies in the system. This  research,  however,  will  help  the  bank  constitute  an effective risk management program with an oversight from the board and senior management. Managing risk requires a top down  approach.  The  quality  of   bank  management  and especially, the risk management process are key in ensuring the safety and stability in the banking system. It is the aim of this research work to encourage the strict adherence to the rules and policies by the operators and regulatory authorities alike.

1.8  OPERATIONAL DEFINITIONS OF TERMS

It is the intention of this portion of the study to define some of the terms used in the work:

Credit: This involves the transfer of money or other property on promise of repayment, usually at a fixed future date.

Risk: Uncertainty of future outcome or the possibility of loss Portfolio:   The   Securities   held   by   an   investor   or   the commercial paper held by a bank

Risk  Assets:  These  relate  basically  to  loans  or  facilities granted to customers

Credit Analysis: A systematic examination or an inquiry that can enhance the decision to lend.

Performing Credit: These are facilities having the payments of both principal and interest repayments as at when due.

Non-Performing  Credit:  These  are  facilities  that  are  not serviced according to the terms of the agreement.

Doubtful Credit: A situation where the principal and/or interest remained unpaid for more than 180 days but less than 360 day

Lost Credit: Facilities with unpaid principal and/or interest remaining  outstanding for  360  days  or  more  and  are  not secured by realizable collateral.

Substandard Credit: Those with unpaid principal and/or interest remaining outstanding for more than 90 days but less than 180 days.

Profitability Ratio: This ratio measures the firm’s ability to earn a fair return from its investment

Efficiency Ratio: Used to calculate a bank’s efficiency

Liquidity Ratio: Measures the firm’s ability to meet its short- term financial obligations as at maturity

Debt Management: This consist of all the activities involved in obtaining funds from depositors and other creditors and determining the  appropriate mix  of  funds  for  a  particular bank.

Asset Management: This comprises the allocation of funds among various investment alternatives.

Prudential Guideline: The guidelines were issued on November  7th,  1990  by  the  CBN  as  an  offshoot  of  the statement of accounting standard No 10 on banks and other financial  institutions.  The  guidelines  were  to  be  strictly adhered to by all banks in reviewing and reporting the performance.

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